A few words on the yield curve

Following the March press statements of the Federal Reserve chairwoman you probably came across articles that were mentioning the flattening of the US yield curve to levels not seen since 2009, mainly on account of a raise in the 5-year rates. The grave tone of such statements I think warrants some clarifications. Hence, this article.

First, the yield curve refers to graphical plotting of the government yields for different maturities. In normal market and economic conditions one would expect this curve to be upward sloping, reflecting, depending on the preferred theory, the higher risk premium associated to longer maturities or the liquidity premium. Notwithstanding that this shape of the curve is rather intuitive there are instances when it becomes flat or even inverted:

- A flat curve is indicative of an economic slowdown and is brought about by a tighter monetary policy which, while increasing short term rates, reduces longer term inflation and growth expectations. Usually, this type of curve precedes an upward or downward slopping curve.

- An inverted curve is widely believed to precede a recession (see Chart below; the grey shaded areas represent recessionary periods). What happens in this case is that the prospect of slowing economic growth and inflation feed expectations of decreasing Central Bank rates and dampens the longer term yields; meanwhile, the short end of the curve remains at high levels reflecting the still tight monetary policy.

To conclude our brief theoretical introduction, we can say that the shorter term maturities are more sensitive to changes in Central Bank’s policy rate, while the longer end of the yield curve is also impacted by growth and, by extension, inflation expectations. For this reason, a tightening of the monetary regime is generally associated with a flattening of the yield curve. That is, the short term rates tend to increase somehow proportionally with the rising key rate, while the longer rates adjust by a smaller degree as the decrease in inflation premium partly offsets the effect of higher short term rates.

It would thus result that the recent flattening of the USD yield curve is normal. There is however a twist: the Fed’s policies are not ordinary textbooks measures. To be clearer, what the Fed tried over the last few years is convincing investors, consumers and financiers that the rates will be low for long so as to keep the short end of the curve anchored at low levels even as the economic data was improving. In this way, the banks, which largely rely on short term financing, are incentivized to extend cheap loans, bringing an increase in economic activity. In March however, all these stakeholders arrived at the conclusion that “for long” might mean sooner than they were expecting and they pushed for a commensurate re-pricing of the short term rates. If the Fed’s message was misinterpreted, this flattening of the yields endangers the success of its policy and we should see a renewal of the “low for long” commitment.

In any case, an increase in the Fed’s monetary policy rate is increasingly likely to happen next year, even if not as soon as the first quarter as the consensus currently indicates. Consequently, a flattening of the yield curve is due to take place, albeit gradually reflecting the paced change in Fed’s rate. In this context, let’s go one step further and see what this means for your bond portfolio.

First, as a general rule, an increase in yields is analogue to decreasing prices and is thus detrimental to return. The magnitude of the effect depends on the size of the yield change and the sensitivity to yield changes (aka duration). Without going into detail, we highlight that longer maturities and lower coupons increase the sensitiveness to interest rate changes. Hence, in the event that the yield curve flattens, the recommended portfolio positioning is not really intuitive; the short term bonds have smaller duration than the longer ones but they won’t necessary outperform because their resilience might be undermined by the magnitude of the change in short term rates.

For this reason, in a flattening yield curve environment, fixed income investors often favor a portfolio that balances the short and the long end of the yield curve. This strategy, aka as barbell, has the advantage of providing sizable income to be reinvested at the increasing interest rates, while keeping interest rate sensitivity at levels commensurate with a rising rates environment. To put it differently, targeting a low duration is not necessarily reducing the exposure to the yield curve changes; two portfolios with similar average duration can perform very differently when the curve flattens reflecting their different exposure to various maturities.

To make this theory more palpable, let’s simulate the returns of short (2 and 5 years) and long (10 year) US Treasuries based on the currently implied forward rates. First, in the Chart below one can observe the shift in the yield curve currently being priced by the forward rates; as theory would anticipate, investors foresee a flattening, with the 2y rates expected to rise by as much as 90 bps and the 10y rates increasing by a more manageable 37 bps.

With this in mind, we can show that if these expectations are accurate, on a total return basis, the longer term US treasuries (UST) should outperform over the following 1-2 years (see Table below).

Note that the increase in yield is partly offset by the bond’s roll down the curve; the chart below exemplifies this for the 5y Treasuries.

However, forward rates are not necessarily good predictors of future interest rates. Investors might misread Fed’s intentions or the economic data might force a change in the timing of monetary policy tightening; actually, this is another reason for favoring a barbell strategy – such a portfolio responses better to unexpected changes in rates given its greater convexity (bond prices decrease at a decreasing rate when yield rise).

To conclude, a barbell portfolio should reduce the impact of volatile rates, a softer flattening or a stronger increase in 10 year UST while providing greater income than a portfolio geared towards the belly of the curve which would have a similar duration.

Before I close, I would emphasize that this article is focused on the current developments in the USD market. By contrast, the EUR market is many quarters away from a potential rise in interest rates with new QE measures still likely; in fact, expectations of new easing measures should keep short rates anchored at low levels.

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